This article is produced by our London Tax team, which is part of our global Tax practice. Our series, "Understanding Tax", explores commercially relevant and recent changes to the UK's tax code.
Opportunities arising from the new UK Hybrid Capital Instruments Regime
Many readers will be all too familiar with the tax pitfalls which can arise from issuing or holding debt instruments which exhibit "equity like" features. Generally such instruments are treated as akin to equity from a tax perspective, with the result that distributions are generally not tax deductible and corporate tax groups can be broken due to the tax status of the holders.
The issues noted above were particularly relevant to banks and insurance companies which were issuing certain types of regulatory capital. As a result, in 2014 the UK introduced a specific tax regime which, in practice, sought to ensure that certain instruments (being Tier I and Tier II regulatory capital) issued by such banks and insurance companies continued to be treated as debt for UK tax purposes (the RCS regime). Whilst the RCS regime was welcomed by the banking and insurance industry it had no application to companies or groups operating outside of these regulated industries.
Introduction of new UK tax regime
- A new, non-sector specific, hybrid capital instrument (HCI) regime replaced the RCS regime with effect from 1 January 2019.
- To fall within the old RCS regime, an instrument had to meet certain regulatory requirements and so the regime was of interest only to banking and insurance companies.
- Unlike the RCS regime, however, the new HCI regime applies to instruments issued by any company, not just banks and insurance companies.
- Accordingly, this raises the opportunity for the HCI regime to be accessed by non-regulated groups, and could potentially be of interest to any group whose business model depends on raising funds efficiently without putting pressure on their level of indebtedness, such as utilities companies.
- Where an instrument falls within the HCI regime, despite having both equity- and debt-like features:
- coupons are treated as interest rather than distributions, and are thus, unlike dividends, potentially deductible for UK corporation tax purposes;
- instruments are treated as "normal commercial loans", meaning they can be disregarded in applying certain UK tax grouping tests; and
- transfers of such instruments are exempt from all UK stamp duties.
- In some respects though, the HCI regime is more narrowly targeted than the RCS regime; in particular:
- the category of instruments to which the new regime applies is narrower and is no longer directly linked to the instruments' characterisation for regulatory capital purposes; and
- fewer tax benefits apply automatically to instruments which qualify (in other words, issuers will need to apply existing general law to determine the tax treatment of their regulatory capital). For example, there is no automatic exemption from UK withholding tax on payments under the HCI regime, and taxpayers will therefore have to rely on another exemption, for example the quoted Eurobond exemption, the UK corporate taxpayer exemption or claim relief under a double tax treaty.
Applicability of HCI regime
- An instrument will be treated as a hybrid capital instrument for HCI purposes if:
- it makes provision under which the debtor can defer or cancel a payment of interest;
- it has no other "significant equity features" (see below); and
- the debtor has made an election in respect of the loan relationship which has effect for the period.
- An instrument will be treated as having no other "significant equity features" if:
- there are no voting rights in the debtor, nor a right to exercise a dominant influence over the debtor;
- any provision for altering the amount of the debt is limited to write-down or conversion events in qualifying cases; and
- any provision for the creditor to receive anything other than interest or repayment of the debt is limited to conversion events in qualifying cases.
- Under the HCI regime, a two-step process needs to be followed:
- first, it is necessary to check the terms and conditions of each instrument to ensure that it meets the definition of hybrid capital instrument for tax purposes; and
- second, it is necessary to apply the tests in each part of the UK tax code which may be relevant to the instrument (e.g. distributions, deductibility, results dependency, withholding tax etc.).
- In summary, the HCI definition is focused on the presence of equity features in the instrument. The regime does not apply if there are arrangements in place with the main purpose of obtaining a tax advantage for any person.
- Unlike under the RCS regime, there is no specific UK withholding tax exemption for hybrid capital instruments and income tax may be deductible from interest paid in accordance with normal UK tax principles.
- It appears that HMRC took the view that a specific exemption from withholding was unnecessary due to the potential availability of a wide range of other exemptions and reliefs in the UK tax code such as the quoted Eurobond exemption, the UK corporate taxpayer exemption and the availability of relief under the extensive number of double taxation agreements to which the UK is a party.
Stamp duty and stamp duty reserve tax
A transfer of a hybrid capital instrument falling within the HCI regime is exempt from all UK stamp duties.